Small caps expected to benefit from resurgent M&A

Uncertainty surrounding Europe, the Fiscal Cliff and the upcoming U.S. presidential election has dampened M&A activity.

In the United States, activity (in dollars) this year has fallen to levels not seen since 2003, but things should start to pick up soon, according to Bank of America Merrill Lynch.

Small cap equity strategist Steven DeSanctis expects a turnaround in M&A activity once the election and Fiscal Cliff uncertainty passes.

“Balance sheets remain solid, the capital markets are wide open, debt to capital ratios are stable and the cost of capital is low,” Mr. DeSanctis told clients. “Private equity firms have plenty of cash in their arsenal and in our opinion could also start a buying spree that may aid the overall market.”

He highlighted the information technology and health care sectors as two areas that should continue to see transactions, noting that balance sheets there are the cleanest and valuations remain attractive.

“Small caps are generally the bigger beneficiaries during M&A booms,” Mr. DeSanctis said, noting that large caps could get a similar boost this time around.

The strategist suggested that the likelihood of large caps overpaying for growth is lower, as valuations for small cap growth stocks are below trend.

He also noted that companies who are willing to part with cash for growth options may be rewarded
rather than penalized. This is because they may be sending the market a signal of more confidence about their ability to continue to generate cash, as opposed to the majority of companies that are hoarding cash due to uncertainty about the future.

Acknowledging the challenges associated with identifying potential takeover targets, Mr. DeSanctis used history as a guide to create a list of 32 large caps and 26 small caps.

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